Tuesday, November 29, 2011

For centuries, gold and silver served as money, but not anymore. Silver went out of circulation in the late 19th century. Gold was effectively banned from circulation in the United States by the Gold Reserve Act of 1934. The last attempt to revive silver in the US as a form of money was made by the Populist Party. In particular, W. J. Bryan, a three-time presidential candidate on the cusp of the 19th and 20th centuries, argued that adherence to the gold standard tightened the money supply and consequently limited access to credit. He claimed that this hurt the entire economy, especially the Midwestern farmers suffering from the deep and prolonged recession of 1890s.

The Populists’ solution was bimetallism – the use of gold and “free silver” – to increase the money supply, which in turn would help the farmers. Their efforts failed, but the debates of those days are immortalized in L. Frank Baum’s The Wonderful Wizard of Oz. According to Henry Littlefield’s famous interpretation of Baum’s fantasy, Dorothy’s silver shoes symbolize the silver money that had to be added to the gold – the yellow brick road – in order for Dorothy’s quest to succeed.*

Money is a special asset. It exists in multiple forms and serves different functions. For example, commodity money such as silver or gold has an intrinsic value, whereas fiat money or paper money has value only as a result of government decree or law. To be used as money, any asset (commodity or fiat) must fulfill the following requirements: It must serve as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. In the modern world, it’s much easier to use paper money than silver or gold coins or bars. However, silver and gold outperform paper money when it comes to the store of value function, because inflation can potentially turn paper money into useless pieces of paper.

Gold is widely used for inflation hedging, which means that when fiat money loses value due to inflation, gold retains its value. The importance of gold as a store of value is underscored by historical price data that shows spikes in the periods of greatest macroeconomic uncertainty. Although not used as a universal medium of exchange, gold still remains an important asset. Its price among pivotal financial market indicators is on a par with Dow Jones and other major stock price indices and Treasury bills.

What about silver? In the past hundred years, it has never come close to gold in importance. The use of silver for investment was negligible until 2008. It was mostly used for industrial applications and for jewelry. Recently, the role of silver has been changing as it becomes an increasingly attractive investment. In 2010, its use as an investment commodity increased to 17 percent of total production. This resulted in an increase in the demand for silver, and consequently, a higher price.

Since then, silver has been appreciating steadily relative to gold. In September 2010, the price of silver was about $20 per ounce, whereas the price of gold was approximately $1,250 per ounce. This yields the gold-silver price ratio of 62.5, which is close to the average for the past two decades. One year later, in September 2011, an ounce of silver was traded for $30 and an ounce of gold for $1,800. Thus the gold-silver price ratio fell to 45. This suggests that silver has begun to function as a store of value and is creeping up on gold. Moreover, current technology significantly increases the liquidity of both gold and silver as assets. Not only is it possible to open an online storage account without leaving your desk, but it is also possible to trade silver and gold shares online without knowing where the metals are physically located.

The quest for a safer investment didn’t just increase the demand for gold, it also dragged silver back into the spotlight. It restored, even if temporarily, silver’s position as a store of value. Even if modern investors don't believe that a pair of silver shoes alone will carry them over the desert of economic instability, they are certainly interested in giving them a try.

* Dorothy’s ruby slippers in the MGM classic movie make no sense economically. Ruby replaced silver for the film because the red ‘popped’ more in the new Technicolor technology.

DISCUSSION QUESTIONS

1. How would expanding the money supply have helped poor farmers at the turn of the 20th century?

2. Would you be willing to accept a gold or silver bar as a means of payment today? Do you think your favorite store at the mall would? Based on your answers, would you say precious metals serve as an effective type of money in our modern society?

3. If two similar investments (like gold and silver) show very different rates of return over the same time period, do you think the investment market is in equilibrium?

Friday, November 18, 2011

I recently had to decide between going to a concert for which I’d already bought a ticket and attending a dinner party with friends. Initially I was compelled to “get my money’s worth” by going to the concert (it was too late to sell the ticket to someone else), in spite of the fact that I would have preferred to go to the dinner (if I hadn’t bought the ticket). According to the economic theory of sunk costs, however, choosing to go to the concert under these circumstances would have been irrational.

Once a good or service has been paid for, the future costs and benefits of actually making use of the purchase should be compared to the future costs and benefits of alternative options—the cost of the purchase, paid in the past, is “sunk” and should not factor into the decision. Suppose that neither the dinner nor the concert would cost me any additional money, but I predicted the enjoyment I would get from the dinner would exceed the potential enjoyment from the concert. Because the expected future benefit minus the (nonexistent) future cost of the dinner exceeded that of the concert, I chose to go to the dinner.

Choosing to ignore sunk costs, however, is not always easy, in part because it can be difficult to distinguish situations in which the cost is truly sunk from those in which it shouldn’t be written off entirely.

Suppose instead I had been asked to bring a bottle of wine to the dinner. In that case, the fact that I had already bought the ticket meant that I was choosing between a concert that would cost no additional money, and a dinner that would cost me the price of a bottle of wine (say $15). Though I would have had a definite preference for going to the dinner and paying $15 for wine over going to the concert and paying $20 for a ticket, it could have been the case that I preferred going to the concert (at no additional cost) to going to dinner (and spending additional money). Although the $20 I’d spent on the ticket was gone either way, it had made one of the options free without affecting the cost of the other option. This would be particularly meaningful if I had a monthly budget for semi-luxuries like concerts and wine, and having spent $20 on the concert, I couldn’t justify spending $15 on a bottle of wine.

The moral of the story is that while you should never consider the “sunk cost” in itself when making decisions, it is relevant to consider how the sunken payment may have altered your current set of options.

Discussion questions:

1. Think about how this kind of analysis would be important to a company that has already invested considerable capital in a project, but later finds a different project that would have been better to invest in. When deciding whether to abandon the first project to invest in the second, how should the money already invested in the first project affect or not affect the decision?

2. Can you think of examples of sunk costs in your life that you might be tempted to not ignore because it can be difficult psychologically to not use things you’ve purchased?

Thursday, November 03, 2011

While at the Patriots-Steelers NFL game earlier this season, I made a classic economics observation: tradeoffs are everywhere. It was partway into the second quarter, and dinner time was approaching. Because our seats were up in the highest section possible, this meant short lines at the concession stands, but the quality of food available was poor. The economist in me couldn’t help but see the natural connection to consumer theory, specifically indifference curves.

Indifference curves express how much utility, or happiness, comes from various combinations of goods. Any two points along the same indifference curve must represent two combinations of goods that make you equally happy. Additionally, points on different indifference curves represent different levels of happiness. In terms of the shape of indifference curves, economists make standard assumptions, such as more is better and averages are preferred to extremes. However, consider what the indifference curve mappings would look like if the goods being represented are quality of food and queue length (that is, the length of time you expect to wait in line .)

In this case, a long queue length is undesirable (economists call this a “bad”).That means that if you’re going to tolerate a longer line, the food quality must improve for you to be equally well off; this translates graphically into the increasing shape of the curve above. Also, for any given queue length, a higher quality of food makes you better off, so the level of happiness represented by IC2 must be higher than that of IC1. Finally, because averages are still better than extremes, the bowedness of the curves must be in the northwest direction. This is illustrated on the following graph:

A and C are two possible consumption bundles, while B represents the average of this bundle. Because B is preferred to A and C and you know that consumers are happier with better food and shorter lines (the southeast direction), the curve must be bowed in this way.

As you can see from the graph above, the choice as to whether or not it makes sense to travel throughout the stadium for better food is a simple consumer choice problem. My optimal decision rests on the relative happiness I get from higher food quality versus not waiting in line. What did I choose? A simple burger with french fries in exchange for a short line, so I could watch Brady and the Patriots blow it!

Discussion Questions:

1. What if instead of modeling “queue length” on the vertical axis, you want to show the indifference curves between “food quality” and the “amount of the game you watch from your seat.” How would the shape of the indifference curves change? Which direction represents a higher level of happiness from one curve to another?

2. Suppose that the value of watching the game diminishes because your team is crushing the opposition. How would this change the shape of your indifference curves between queue length and food quality?

3. What if averages are no longer better than extremes? How would that alter the shape of the indifference curves shown above?